Similar to the report we prepare for owner-occupants, the report cover sheet contains summary information including pictures, the address, and a few identifying characteristics. The first piece of summary data is the asking price, and this is followed by the Comparable Value, and the Likely Transaction Price. There is no IHB Fundamental Value. Cashflow investors are not interested in how we may value the property, they want to know what rates of return are available, and they can decide their own price based on the cashflow. We provide the necessary data to make this determination.
Capitalization Rate and Cash-On-Cash Return
One key concept for Investment Value of Residential Real Estate is capitalization rate. The Capitalization (cap) Rate is the (yearly) Net Operating Income divided by Asking Price (assumed purchase price). It is the simplest measure of an investment’s financial performance, and it provides a convenient comparison to competing investment alternatives. A cap rate is like an interest rate on a checking account, a mutual fund return, or a bond yield. Cap rates change over time to reflect the perception of risk in real estate as compared to other investments. Speaking of mutual funds, Parnassus endeavor returns on investments are the result of fundamental research to determine a company’s financial health and its business prospects. This is the way to ensure the return of investment.
The cap rate is inversely related to price; in other words, high cap rates are synonymous with low prices and visa versa. The cap rate an investor will accept varies from person to person. There is no single appropriate rate to apply to value. Instead, we show a range of values at different cap rates to show the current investment return someone can expect from this property.
The Cash-On-Cash Return is similar to a capitalization rate in that it shows a return on investment, but it is measured by comparing the Total Profit and Loss after Expenses, Debt and Taxes to the Total Cash Costs. This is the important rate of return for investors who are not purchasing with all cash. As long as debt is less expensive than the cap rate, the cash-on-cash returns can be magnified by increasing debt. This is an appropriate use of leverage to increase investment returns — to a point.
This property, even with a $360,000 asking price, only reflects a 3.67% cap rate. You would be better off in 10 year Treasuries. Since the cap rate is less than the interest rate (cost of debt), applying a mortgage to the property actually hurts the returns. This very unusual circumstance reflects how low cap rates became and how much the market was depending on appreciation.
Rental Income, Operating Expenses and Net Operating Income
An accurate estimate of income and expenses is required to value a property based on cashflow. The Gross Rent is the monthly rental rate pulled from comparable properties. Assuming this rent can be obtained, an allowance for Vacancy and Collection Loss is subtracted to arrive at a realistic Monthly Rental Income. The Operating Expenses are those fees and costs typical of rental properties. This does not include any financing or tax implications.
Many properties are purchased by wealthy individuals looking to diversify their holdings among asset classes. These investors want to deploy capital with safety and obtain a periodic, measurable return on their investment. Under those circumstances, the properties are purchased without debt. The preponderance of all-cash investments creates the need to view the investment on an all-cash basis.
Net Income is Rental Income minus Operating Expenses. The capitalization rate is based on Net Income. It is the rate of return on the investment when no debt is utilized. Once you introduce debt, returns get magnified, but so do the risks. This spreadsheet allows viewing different financing alternatives.
There are a few different line items to consider when the property is a rental investment. The Maintenance and Replacement Reserves are often double the cost of an owner occupied property. Unless you are managing the property yourself, there will be a Property Management Fee for someone to handle tenant issues. There will also be expenses related to your owning the property through tax filings and other Miscellaneous Expenses.
Financing and Taxes
The financing and taxes are considered separately because some owners do not finance the purchase. There are two items of note in this section as it differs from the owner occupant version. (1) The Tax Savings % will be your highest marginal tax rate. The assumption is that an owner of investment property has already given up the personal exemption, so any interest write off would be at the highest marginal rates — there is one caveat — the property must positive cashflow for the write-off to be allowed.
(2) The opportunity cost is ignored. The whole point of calculating the cap rate or the cash-on-cash return is to establish a value to compare to your opportunity cost. To try to adjust for it here would make the results inaccurate. It would be like comparing twice or double counting.
Cash Acquisition Demands
The Cash Acquisition Demands is similar to the owner occupant version except that the emergency cash reserves are removed. Emergency cash reserves is an important financial planning consideration for an owner-occupant, but an investor has other concerns.
Comparative Sales Value and Negotiating Range
This table is similar to the owner-occupant version as it shows the recent comps and projects negotiating ranges. When we estimate the Likely Transaction Price, we look at comparables and adjust it for the market trend. In order to see the reasoning behind our determination, I have added the Short Term Direction of Prices.
Capitalization Rates and Property Values
The Capitalization Rates and Property Values section replaces the Cashflow Value and IHB Fundamental Value section. As I said, each investor has their own required rate of return, so rather than present what we believe to be the right value, we show investors a range of values based on the cashflow. An investor who demands higher cap rates will bid more conservatively, and a more aggressive investor will bid higher.
Asking Price and Value Ranges
As with the owner-occupant version, the information is presented in a graphic form. The property values at different cap rates makes for an interesting view of pricing.
I base my prediction of a unit in this complex selling for under $200,000 from the chart above. The cap rate values are so low they fall off the bottom of my chart. Cap rates have to stay under 6.5% for this property not to fall below $200,000.
Comparable Sales, Comparable Rentals and Notes
This is the new and improved section based on the feedback from readers asking for the dates of the comparables. The notes are different including a section on the Capitalization Rate and Cash-On-Cash Return.